Retirement Accounts: Restorative Payments vs. Return of Human Capital

If you get something returned to you, you generally do not pay income tax on the return. You just get your property back. It can be difficult to tell whether you are getting your property back or getting some other property back. Is there a difference? Or should there be a difference?

The court grappled with this in the Murphy v. IRS, 460 F.3d 79 (D.C. Cir. 2006), case last year and recently reconsidered and vacated its own opinion on the matter. The case gets into the question of whether payments received for damages to a person are a return of capital.

The court eventually said, “no.” But this return of capital is very similar to “restorative payments” in the context of retirement accounts. Even if there is no return of human capital, why is there no tax on restorative payments for retirement accounts?

Facts & Procedural History

In this article, we’ll provide the facts and procedural history of the Murphy case, even though that case is not the focus of this article. The article focused on the private letter rulings for retirement accounts described below. The Murphy case sets up the issues in these rulings.

The taxpayer sued her former employer to recover compensatory damages for emotional distress and loss of reputation under whistleblower statutes. The taxpayer was awarded compensatory damages of $70,000, of which $45,000 was for “emotional distress or mental anguish” and $25,000 was for “injury to professional reputation.”

The taxpayer reported the $70,000 award as part of her “gross income” and paid $20,665 in Federal income taxes based upon the award. The taxpayer sued the IRS to recover taxes paid as a result.

The taxpayer argued that the damages should have been excluded from her gross income because they were compensation received “on account of personal physical injuries or physical sickness” under Section 104. She pointed to her physician’s testimony that she had experienced “somatic” and “body” injuries “as a result of NYANG’s blacklisting [her],” and to the American Heritage Dictionary, which defines “somatic” as “relating to, or affecting the body, especially as distinguished from a body part, the mind, or the environment.” The taxpayer further argued that the dental records she submitted to the IRS proved she has suffered permanent damage to her teeth.

The courts did not agree that the taxpayer’s compensation was received on account of personal physical injuries and was excludable from her gross income under Section 104(a)(2).

The “In Lieu Of” Anaysis

The taxpayer also maintained that the exclusion of such compensation from gross income was required by the Sixteenth Amendment to the Constitution.

On appeal, the court agreed. It held that Section 104(a)(2) was unconstitutional as applied to her because compensation for a non-physical personal injury is not income under the Sixteenth Amendment if it is unrelated to lost wages or earnings. The appeals court reasoned that the Sixteenth Amendment does not give Congress the power to tax every sort of revenue a taxpayer may receive and that the power to tax income extends only to “gain” or “accessions to wealth.”

The court then applied the “in lieu of” test to determine whether the taxpayer’s compensatory damages for emotional distress and loss of reputation can be considered income. It concluded that the damages were not received “in lieu of” something normally taxed as income and that compensation for a personal injury, including a nonphysical injury, would not have been considered income by the framers of the Sixteenth Amendment. As a result, the appeals court held that the provision permitting the taxation of such compensation is unconstitutional and remanded the case to the district court for a refund of the taxes paid on the award.

Word of this case spread as did questions about the court’s decision, mostly by tax professionals, which resulted in the court reconsidering its own opinion. The court vacated the opinion, effectively reversing its own decision.

Restorative Payments vs. Return of Human Capital

In the wake of the Murphy case, some have questioned the distinction between “restorative payments” and payments that are a “return of human capital.”

Restorative payments, such as the compensatory damages awarded to the taxpayer, are intended to make the injured party whole again and compensate them for a loss they suffered, such as emotional distress and damage to their reputation. According to the courts initially, in this case, these payments are not considered income under the Sixteenth Amendment because they are not received in lieu of something that is normally taxed as income.

On the other hand, return of human capital refers to compensation for lost earning capacity or wages. This type of compensation is considered income under the Sixteenth Amendment and is taxable. The court noted that the taxpayer did not receive compensation for lost wages or earning capacity, but rather for nonphysical injuries. Therefore, the compensation she received is not considered income under the Sixteenth Amendment.

Comparison to Restorative Payments

The court’s original position in Murhpy is supported by some tangential authority, such as Revenue Ruling 2002-45, where the IRS stated that amounts paid by an employer to employees for losses associated with improper investments in the employer-provided defined contribution plan, if the contributions are paid into the qualified plan, are not considered “contributions” and are not subject to contribution limits. Instead, these amounts are considered “restorative payments” up to the amount lost, which compensate for a breach of fiduciary duty and not for losses due to market fluctuations.

The IRS has applied this logic to IRA payments in Private Letter Ruling 200705031, where a taxpayer received a “restorative payment” from a financial institution to restore losses resulting from the financial institution breaching its fiduciary duty to invest prudently. The IRS made this ruling even though the taxpayer held the “restorative payment” in a separate taxable account and missed the sixty-day deadline for contributing the payment to another IRA.

However, these private letter rulings do not explicitly state whether these “restorative payments” are taxable income to the recipients. In Private Letter Ruling 200137065, the IRS expressly stated that “restorative payments” were not taxable income to the recipients under similar facts.

The difference between “restorative payments” and payments that are a “return of human capital” is that restorative payments compensate for a breach of fiduciary duty regarding retirement accounts, while a return of human capital compensates for a loss in the value of the taxpayer’s own skills or reputation. The rule is that payments to compensate a taxpayer for harm to their retirement account are not taxable, while payments to compensate a taxpayer for harm to their person are generally taxable.

These non-physical injury cases are challenging, as the law is not entirely clear. Another example is an award involving litigation with a mortgage company that botched a loan. Is this restoring the amount of the house and a reduction to tax basis or is this income? This is one of the numerous fact patterns that there is no real answer to.

The Takeaway

In conclusion, the Murphy case raised important questions about the taxation of compensatory damages for non-physical injuries under the Sixteenth Amendment. The court initially held that such compensation is not taxable under the “in lieu of” test, but later vacated its decision. The distinction between “restorative payments” and payments that are a “return of human capital” is significant, as restorative payments are generally not taxable while return of human capital is taxable. However, there is some uncertainty about the taxability of restorative payments, as evidenced by the IRS’s own private letter rulings on the matter.